One of the more interesting provisions in the recently passed American Taxpayer Relief Act (ATRA) is the ability to do a Roth conversion within a 401(k) plan. Before January 2nd, employees were mostly prevented from moving assets from the traditional, pre-tax portion of their 401(k) to a Roth component of the same 401(k) plan. While it was available to those employees who otherwise were eligible to take a distribution from the plan, that was rather limited. With the passage of ATRA, Congress has opened up the opportunity for anyone to move assets from the traditional, pre-tax portion of the 401(k) plan to the tax-free, Roth portion of their 401(k).
(In the financial community, the process of moving assets from a traditional account to a Roth account is called “converting” — a Roth conversion.)
To be clear, it is not a matter of simply moving assets from the traditional 401(k) account to the Roth account. In order to do this, you have to pay taxes – at your current income tax rate – on however much you convert. But the end result is that the assets will now grow tax-free and will be distributed income tax-free (under most circumstances).
Who Will This Affect?
The impact on this is probably fairly limited to most people – or at least it should be. However, the obvious segment of the population that this benefits are those young people – likely still in their 20s or early 30s – who are on an upward trajectory in their career paths, have some savings in the traditional 401(k) plan, and aren’t already in a high tax bracket that they anticipate will fall in retirement.
In other words, it makes sense for people who expect to be in a higher tax bracket when they start taking distributions from the account.
Should You Convert?
So ATRA opened up the possibility for people to move assets from the traditional 401(k) to the Roth 401(k), but should you do it? It depends on two factors – one of which is a complete unknown for most:
- Do you expect to be in a higher tax bracket in retirement than you are in now? If the answer is yes, then you should convert assets now… as long as you can answer yes to the next question.
- Do you have the cash to pay the taxes today – or technically next year on April 15th? In order to convert the assets from the traditional account to the Roth account you have to pay income taxes on it today.
For parents of young adults who see the value in the Roth account and have the cash available to help their children, this may be a very good opportunity. Talk to your adult children about it, get an understanding of their current tax picture, and find out how much they have in their 401(k). If they have a lot – or more than you are willing to gift them to pay the taxes – then consider advising them to do a partial conversion. In other words, if they have $25,000 in the traditional 401k and you only wanted to give them $2,000 to pay the taxes, then figure out how much they can convert and not incur more than $2,000 of additional taxes — or ask your financial professional to help you. (A quick example: In the 10% tax bracket, $2,000 of income tax would be levied on $20,000 of taxable income.)
For those without parental assistance, you can still take advantage of this opportunity but will need to be mindful of your tax bill. Create a savings plan to help you set aside the funds needed each April 15th to pay the higher bill. A financial advisor can help you determine what your bill might be and whether or not it makes sense for you to have more taxes withheld with each pay check or develop an automatic savings contribution to the account you will use to pay the taxes.
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